NOS, SGPS, S.A. Primary Credit Analyst: Thibaud Lagache, Paris (33) 1-4420-6789; [email protected] Secondary Contact: Xavier Buffon, Paris (33) 1-4420-6675; [email protected] Table Of Contents Credit Highlights Outlook Our Base-Case Scenario Company Description Business Risk Financial Risk Liquidity Covenant Analysis Issue Ratings - Subordination Risk Analysis Reconciliation Ratings Score Snapshot Related Criteria WWW.STANDARDANDPOORS.COM/RATINGSDIRECT FEBRUARY 12, 2020 1 NOS, SGPS, S.A. Business Risk: SATISFACTORY Issuer Credit Rating Vulnerable Excellent bbb- bbb- bbb- BBB-/Stable/-- Financial Risk: INTERMEDIATE Highly leveraged Minimal Anchor Modifiers Group/Gov't Credit Highlights Overview Key strengths Key risks Leading position in Portugal's pay-TV market, a well-established Direct competition with two other strong brands (Altice, owned by presence in fixed broadband as the close no. 2 operator, and a distant Portugal Telecom (PT) and Vodafone), that operate overlapping platforms no. 2 position in the postpaid mobile services market. and offer converged services within Portugal's small service area. Well-invested fixed networks provide over 100 megabits per second Mature, highly penetrated market, and on-going fiber deployment will (Mbps) to more than 73% of broadband customers, supporting higher further limit network and speed differentiation. fixed average revenue per user than for competitors. Flexible fixed-mobile offering, strong local content, and a Heavy capital expenditure (capex), including spending on networks, well-established brand have fueled solid organic growth of about satellite capacity, subscriber acquisitions costs, and catching up with 3.3% over 2014-2018. competitors in terms of 4g mobile coverage. A strong balance sheet and sound financial policy with targeted Entrance of Masmovil (via a stake in Cabovisao/Oni) in the Portuguese leverage of about 2.0x. The ability to monetize its mobile network market, together with the rising penetration of over-the-top (OT) providers infrastructure provides additional flexibility. could intensify competition. NOS, SGPS, S.A. is Portugal's second largest national and converged operator. The company's historically strong pay-TV offering and its no. 1 position in the pay-TV market has resulted in a solid share of net adds across all services since mid-2014, thanks to a nationwide next generation network (NGN) covering about 90% of households through fiber to the home (FTTH; about 31%) and Docsis3.1 cable (about 69%) as of Sept. 30, 2019. NOS' well-invested fixed networks providing broadband speed of over 100Mbps to more than 73% of broadband customers, strong local content, and very flexible "pick and mix" tariff plans have led to high revenue generating units (RGU) per subscribers, supporting higher fixed ARPU than competitors. WWW.STANDARDANDPOORS.COM/RATINGSDIRECT FEBRUARY 12, 2020 2 NOS, SGPS, S.A. Chart 1 Chart 2 WWW.STANDARDANDPOORS.COM/RATINGSDIRECT FEBRUARY 12, 2020 3 NOS, SGPS, S.A. Chart 3 Chart 4 WWW.STANDARDANDPOORS.COM/RATINGSDIRECT FEBRUARY 12, 2020 4 NOS, SGPS, S.A. S&P Global Ratings expects NOS will continue to show organic single-digit revenue growth, supported by improving macroeconomic conditions, a sustained pace of growth in more value-added convergent bundles, and steady price increases despite tough competition. We expect this growth will also be supported by the increasing coverage of its 4G+ mobile network and the ongoing upgrade of its fixed network. This follows the reciprocal fixed-network sharing agreement it reached with Vodafone in 2017 and DS Telecom in 2019 to swap approximately 2.6 million and 1.2 million households, respectively, to fiber-to-the-home (FTTH) technology by 2022. We expect that, by 2022, about 70% of NOS' footprint (3.1 million Portuguese households) will use FTTH technology compared with 31% today. NOS' integrated and convergent subscribers represents about 60% (914,800) of the total base, leaving additional room for growth. Additionally, we believe NOS' margins will likely improve further due to increasing operating leverage. Chart 5 WWW.STANDARDANDPOORS.COM/RATINGSDIRECT FEBRUARY 12, 2020 5 NOS, SGPS, S.A. Chart 6 The mature, highly penetrated nature of the Portuguese market, as well as fiber deployment, will further limit network and speed differentiation. Although customer acquisition and retention capex have declined since 2014 from 14.5% of revenue, we expect they will remain at about 9%-10% in 2020 and beyond due to Altice's intense fiber deployment, and rising competition from new market entrants. That said, we believe NOS' strong brand recognition and local content offering (sport, and local shows for example), outside of OTT services, will continue to provide solid protection against price competition. NOS has set ambitious targets and sought partnerships to deploy fiber and to remain independent from Altice's FTTH network, which we believe will continue to support solid pay-TV net customer additions, which are the basis for upselling its convergent offers. WWW.STANDARDANDPOORS.COM/RATINGSDIRECT FEBRUARY 12, 2020 6 NOS, SGPS, S.A. Chart 7 Chart 8 WWW.STANDARDANDPOORS.COM/RATINGSDIRECT FEBRUARY 12, 2020 7 NOS, SGPS, S.A. Outlook: Stable The stable outlook reflects our expectation that NOS will continue to leverage its attractive brand and solid market position, deliver organic revenue growth, and gradually increase margins. We think this will position the company comfortably at our 'BBB-' rating level, with S&P Global Ratings' adjusted leverage comfortably below 2.5x and free operating cash flow (FOCF) to debt over 10%, steadily rising on moderating investments and increasing absolute EBITDA. Downside scenario We could take a negative rating action if adjusted leverage increased for a prolonged period above 2.75x, or if FOCF to debt deteriorated significantly below 10%. In our view, this could occur from a more aggressive financial policy than we foresee, if NOS experienced declining revenue, or if margins started to deteriorate, for example as a result of a market-wide price decline, which seems unlikely at this stage. Upside scenario We could raise the rating if NOS' performance is stronger than our base-case expectation and translates into FOCF to debt significantly above 15%, and adjusted leverage sustainably reducing toward 2.0x. Our Base-Case Scenario Assumptions Key Metrics • Portuguese GDP per capita will reach above $25,000 by 2021, following GDP growth of about 2.1% in 2018a* 2019e 2020f 2018 and about 1.6%-1.8% over 2019-2020, mainly Revenue growth (%) 0.9 1.3 1.1 driven by continued solid economic growth; and the Adjusted EBITDA margin (%) 39.3 37.9 39.2 unemployment rate will decline to 6.0% by 2019. Capex/sales (%) 26.9 26.3 26.0 Adjusted debt/EBITDA (x) 2.2 2.3 2.3 • The Portuguese telecom market will expand primarily from price increases and rising Adjusted FFO/debt (%) 42.8 40.0-41.0 40.0-41.0 convergence adoption or service migration Adjusted FOCF/debt (%) 17.4 10.0-12.0 12.0-13.0 (vDSL/FTTB to FTTH), rather than from subscriber or household growth, which we expect will increase *2018 includes the positive impact of a non-recurrent in line with inflation. We believe this is due to the inflow related with the receipt of a legal settlement in already high penetration of telecom services (about favors of NOS. 170% mobile penetration per population, about 75% and 90% of broadband and pay-TV penetration per a--Actual. e--Estimate. f--Forecast. FFO--Funds from households, respectively). operations. • NOS' total revenue will increase by about 1.2% over 2019-2021, driven by business and wholesale, telecom and audiovisuals, and cinema. WWW.STANDARDANDPOORS.COM/RATINGSDIRECT FEBRUARY 12, 2020 8 NOS, SGPS, S.A. • We anticipate consumer revenue will increase by 0.3% on average per year over 2019-2021, driven by yearly price increases (slightly above inflation rate) in convergent packages, further adoption of quad-play packages, with convergent customers reaching about 60% of the pay-TV base by 2020, and NOS' network expansion. We expect this will in turn support continuous, although moderate, RGU growth (1% on average per year) and fixed ARPU growth. • Business and wholesale revenue will increase by 2.3% on average per year, supported by additional contract wins, RGU growth, and price increases. • About 2% growth in the audiovisual and cinema business. • S&P Global Ratings' reported EBITDA margins (after leases) will improve to 38%-39% over 2019-2021, from 37%-38% in 2017-2018, stemming from revenue growth and an improved customer mix. • Total reported capex (including long-term contracts) will remain at 25.0%-26.0% of revenue over 2019–2021, from 26%-28% in 2017-2018, excluding spectrum costs for 5G. Capex will mainly stem from the continuing FTTH upgrade and mobile network overhaul that NOS initiated in late 2017 to optimize spectrum utilization and improve capacity for 4G+ technology, while complying with coverage obligations. We expect capex could be slightly lower if NOS and Vodafone go ahead with sharing their full mobile networks. • Our expectation of distribution of the bulk of reported FOCF (after leases) in dividends (€180 million paid in 2019) Base-case projections We expect solid reported cash flow (after leases) conversion and growth will continue, driven by network expansion and continued subscriber migration. We forecast reported FOCF after leases will increase by about 15% on average per year over 2019-2021. Adjusted leverage will remain at about 2x. Stable capex of about 26% of revenue and ongoing EBITDA growth will keep leverage well below 2.5x, despite moderately increasing revenue and shareholder distributions. WWW.STANDARDANDPOORS.COM/RATINGSDIRECT FEBRUARY 12, 2020 9 NOS, SGPS, S.A. Company Description NOS is the no.2 largest telecom operator in Portugal, behind the incumbent PT (acquired by Altice in January 2015) and ahead of Vodafone Portugal. Both in terms of revenue and subscribers, NOS is the no.1 in pay-TV, close no.2 in fixed broadband, and no.2 in postpaid mobile.